Short selling, or shorting, is a method that experienced investors can use to profit on the decline of a stock's price. Shorting is the opposite of buying in that you lose money when a stock increases in value and make money when a stock decreases in value.
How Does Shorting Work?
The process for shorting is fairly simple. To short, an investor borrows a stock from their broker and then sells it on the open market. At a future point in time, the investor buys back the stock then returns it to their broker. The difference between the initial sale price of the stock and the price that the stock was bought back at represents the investor's gain/loss on the trade.
For example, say we want to short MSFT, which is trading at $100/share. We would borrow 1 share of MSFT from our broker and sell it on the open market for $100. Now let's assume that MSFT declines in value to $95/share. We would then buy back 1 share of MSFT on the open market for $95 and return it to our broker, leaving the us with a $5 profit (5% return).
Now let's assume that instead of declining in value, MSFT appreciates in value to $105/share, and we decide to close our short position at this price. In this case, we would lose $5 on this trade (5% loss).
Hidden Costs of Shorting
Now that we know how shorting works, let's discuss the hidden costs associated with it: margin rates and borrow rates.
Margin is money borrowed from a broker to purchase an investment. Margin is needed to short because it is used as a form of collateral to reasonably ensure that borrowed shares will be returned to the broker in the future. Because margin is essentially a loan from the broker, there is interest that is charged on it known as the margin rate. Rates differ from broker to broker, but generally range between 2%-10%. More experienced investors with higher account balances will typically enjoy lower margin rates.
The borrow rate is simply the cost to borrow a stock. We know that when an investor shorts a stock, they borrow the stock from their broker. The broker must source that stock from somewhere, either from the broker's own account or from other investors. The original owner of the borrowed stock is compensated for loaning it out with borrow rate. Borrow rates vary from stock to stock, but is generally less than 1% (annually) of the stock's price. As the supply of a stock available to borrow decreases, the borrow rate increases. This often happens with highly shorted stocks.
In our MSFT example above, we would have to subtract fees paid for margin and borrow in order to calculate the our true gain/loss.
Shorting is used primarily for two purposes: Trend speculation and hedging.
Let's talk about trend speculation first. Just like investors can buy a stock to speculate on a potential increase in value, investors can also short a stock to speculate on a potential decline in value. This can be useful to bet against individual stocks or the market as a whole. For example, if an investor believes that a company will miss earnings, they might short the stock before its earnings report. Or perhaps an investor believes the market as a whole will decline because the Fed will implement monetary tightening measures. They might short an S&P 500 ETF in order to profit. This is what many investors did during the 2008 Recession. If you haven't seen The Big Short yet, check it out.
I generally would not recommend shorting for the purposes of trend speculation because it is very hard to get right. If we look at the history of the stock market, we will see that stock's go up more than they go down. This is a function of corporate earnings growth as well as human nature. If we were to short based on trend speculation and get the timing wrong, our losses could potentially be catastrophic.
The other main reason to short is for hedging purposes. Hedging is a risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset. This method is typically used by hedge fund managers running long/short and market neutral strategies.
For example, let's say we have a large long position in FB, however, we are worried about potential weakness in the tech sector caused by rising interest rates. We could hedge all or part of our FB position by shorting a related stock, say GOOGL. In this case, if the tech sector were to decline, both FB and GOOGL would also likely decline. We would lose money on our FB long position, but those losses would be offset by gains in our GOOGL short position.
It's important to note that shorting for hedging also comes with considerable risks and should only be undertaken by experienced investors. This is because two correlated stocks may not always move in the same direction. In our example above, if FB declined in value but GOOGL remained flat or even increased in value, then our losses would have been magnified. For this reason, hedge fund managers and sophisticated investors generally employ complex models to short for hedging purposes.
Risks Associated with Shorting
Let's discuss two of the biggest risks associated with shorting: Infinite potential for loss and short-squeezes.
In a long position, your potential for loss is capped at 100%. Although this rarely happens, you will never lose more than you invest in a long position. For shorts, however, this is not the case at all because losses happen due to asset appreciation. What happens when a stock that was shorted at $5/share increases in value to $15/share? In this case, there would be a loss of 200% — ouch!
Short-squeezes happen when a crowded short's stock price shoots up and creates a positive feedback loop. A stock's price increases, which triggers some short sellers to exit their positions in order to prevent losses. Because shorts are exited by buying stocks back, this increases the price of that stock. This additional increase in the stock's prices triggers other short sellers to exit their positions. And so on...
This is famously happened with GameStop (GME) in January 2021.
In this article, we learned what shorting is and the risks associated with it. The biggest takeaway is that I would advise the average investor to avoid shorting because the risks do not typically outweigh the benefits. Shorting is extremely difficult for even professional investors. Most hedge funds actually lose money overall on their short over the long-term.
If you are concerned about market weakness or want to hedge your portfolio against systematic risk, I would advise holding cash instead of shorting. For example, instead of being 100% invested in the market, you might reduce your exposure to 50%, meaning you are holding 50% of your portfolio in cash. This way, you are truly reducing the risk of your portfolio without introducing new risk from shorting.